Greenspan's real conundrum: short-term rates

Page Tools

When long-term rates get a mind of their own, what's a
good central banker to do? Caroline Baum considers the
options.

Ever since Federal Reserve chairman Alan Greenspan made
"conundrum" a household word in February, the term has been used to
describe the behaviour of long-term interest rates.

This is the first time in recorded financial history that the
Fed has jacked up short-term rates only to find long-term rates had
a mind of their own. The yield on the 10-year Treasury note is
about 75 basis points lower than it was before the Fed first raised
rates on June 30, 2004. The overnight federal funds rate is 200
basis points higher.

So what's a good central banker to do? Will the Fed keep raising
short-term rates, even if it means inverting the yield curve, in a
bid to normalise rates and subdue the housing market? Or will
policymakers heed the message inherent in a flattening yield curve
and quit? This is Greenspan's real conundrum.

The Fed has given no hint of an end to the cycle of rate
increases, which have lifted the funds rate to 3 per cent.

The statement after each meeting reiterates the belief that
monetary policy remains accommodative. Compared with the 3.5 per
cent rise in the consumer price index in the past year, the
inflation-adjusted funds rate is negative. (That means banks are
being paid to borrow.) The real funds rate has been below zero for
almost three years, the longest stretch since the mid-1970s.

Fed officials have said in every way except in the policy
statement that they're more concerned about accelerating inflation
than slower growth. Given their focus on wages as the driver of
inflation, last week's news that unit labour costs in the non-farm
business sector had risen at 4.3 per cent over the past year beeped
on their radar screen.

The inflation news isn't great either. While the CPI, excluding
food and energy, was unchanged in April from March, prices for
services, excluding energy, rose at a three-month annualised rate
of 3.8 per cent.

Greenspan's dilemma - his real conundrum - isn't long-term
interest rates, which are set by the market. It's what to do with
the short rate.

Let's assume the Fed delivers on market expectations for a
25-basis-point rise at its June 30 and August 9 meetings, taking
the funds rate to 3.5 per cent. There is no reason to expect
long-term rates to rise.

Come the September 20 meeting, Fed officials will be confronted
with a flat yield curve. What will Greenspan do?

There's no sign of easing. And the last thing Greenspan wants to
do is goose the housing market by giving markets the green
light.